Invoice financing is a general term that applies to several products that allow you to finance accounts receivable. The two most-used solutions are factoring and sales ledger financing. In this article, we discuss both solutions in detail. The article covers:
- Quick summary
- What is factoring?
- What is sales ledger financing?
- Which solution is right for your company?
1. Quick Summary
Factoring allows your company to sell its invoices to improve your cash flow. The factoring company buys your invoices and provides you with an immediate payment. The payment provides funds to run and grow the business. Small and midsize companies commonly use factoring to improve cash flow.
Sales ledger financing provides a revolving line of funding secured by your accounts receivable. Much like factoring, this financing line improves your cash flow. However, the ledger lines work differently and are commonly used by larger companies. Ledger lines are considered a stepping stone to getting a bank line of credit.
Both financing solutions provide similar results for the client. However, they use different approaches and structures. They also have different cost structures.
2. What is invoice factoring?
Factoring is the simplest form of invoice financing. It allows companies to sell their accounts receivable to a factoring company. In exchange, the client gets an immediate payment. The transaction is structured as the sale of an asset. Consequently, it has fewer restrictions and is easier to underwrite than a conventional loan. The funds can be used for any business purpose, such as:
- Launching new projects
- Hiring employees
- Buying supplies
- Paying for company expenses
Most companies can get a factoring line established in a couple of days. Once the line is established, most invoices take a day to finance. This solution works well for companies that offer net-30-day terms to clients but need to get paid sooner. Learn more about the advantages of factoring.
a) How does factoring work?
Most factoring transactions are structured as a two-installment invoice sale. The first installment payment covers about 80% of the value of your invoices. It is deposited to your account within one business day of requesting funds (i.e., selling your invoices). As a second installment, your company gets the remaining 20%, less the finance fee. Your company gets this installment once the customer pays the invoice in full.
Some transactions in the trucking industry are financed using a single payment instead. In this case, the factoring company finances the invoice in one installment of 95% to 98% of the invoice value. Factoring lines are based on your sales volume. Therefore, lines can increase as your sales to creditworthy commercial clients grow. Learn more about factoring and how to choose the best factoring company for your business.
b) How much does factoring cost?
The cost of most factoring lines ranges from 1.15% to 4.5% per 30 days. Lines can be structured in different ways based on your specific situation. For example, a line that averages 2% per 30 days can be provided as follows:
- 0.67% per 10 days (0.67% x 3 = 2%)
- 1% per 15 days (1% x 2 = 2%)
- 2% for the first 30 days; 0.67% per 10 days after that
The final structure is flexible and based on what works best for you and the factor. Learn more about factoring costs and typical rates (by industry).
c) How does a company qualify for factoring?
Factoring is easier to get than conventional financing because of the structure. Your company is selling an asset rather than getting a loan. To qualify, your company needs to:
- Have creditworthy commercial clients
- Be free of encumbrances (liens and judgment)
- Have good invoicing practices
- Invoice for delivered goods/services
Invoice factoring is available to small and midsize businesses, including new companies and companies with few (if any) assets. Learn if you qualify for factoring.
3. What is sales ledger financing?
Sales ledger financing is a specialized form of asset-based lending that works like a line of credit secured by accounts receivable. They are also referred to as ledgered lines. Sales ledger financing is an intermediate product between factoring and a bank line of credit. Ledgered lines are harder to get than factoring but are easier to get than a bank line of credit.
Setting up a facility takes about three to four weeks, depending on the size and complexity of the opportunity. After setting the line, getting funds takes a day or two. Companies can request funds on a schedule that meets their needs.
Sales ledger financing lines require more documentation than a factoring line. They work best for companies that invoice at least $350,000 per month. Your company must have good financial statements and a track record of profitability. Learn more about sales ledger financing.
a) How does sales ledger financing work?
The solution works much like a conventional line of credit. It allows your company to draw funds up to a credit limit. Your revenues and other variables determine the credit limit. On average, lines allow you to borrow up to 85% of the value of your eligible receivables. However, this amount varies based on your industry, client concentration, and A/R credit quality.
The client fills out a funds request to access funds, which contains a list of accounts receivable. In combination with collections reports, this information determines the maximum amount of the draw.
Ledgered lines can be used only by companies that keep an up-to-date accounting system. Otherwise, the company won’t be able to generate or reconcile funding requests.
b) How much do sales ledger financing lines cost (A/R only)?
The cost of financing is based on the prime rate, using what is called a “prime plus” structure (as in “prime plus X%”). Yearly rates range from “prime + 3%” to “prime plus 7% “. The cost averages 8% to 14% per year using current rates and varies with the prime rate.
Your company’s financing rate is based on sales volume and transaction risk. Generally, higher volumes and a diversified client base get you the best price. Ledger lines of credit tend to be less expensive than factoring lines of comparable size. In some cases, companies have to pay a due diligence fee as well. This fee helps defray the costs of due diligence and setting up the line. These costs vary based on the complexity of the transaction.
4. Which solution is the right one for your company?
The product that works best for you depends on several criteria. They include your:
- Company size
- Financial strength
- Track record
- Specific needs
Companies that need less than $350,000 of financing are well suited for factoring. Additionally, companies that aren’t profitable or are in turnaround mode are good candidates for factoring. Factoring lines have no (or minimal) upfront costs. These financing lines are simple, relatively easy to get, and quick to set up.
Companies that need between $350,000 and $750,000 are in a borderline situation. In the right circumstances, they could qualify for a sales ledger financing line but could be better served by factoring. Use both solutions’ economics and operations complexity to determine which works best for you.
Lastly, companies that need more than $750,000 and are in reasonable financial shape should consider a sales ledger financing line. This solution offers the best price, flexibility, and control.
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